Published : July 5, 2020
“Derivative markets want volatility, that’s where all the trading opportunities present itself,” says Azila Abdul Aziz, the CEO and executive director, head of listed derivatives, of Kenanga Futures Sdn Bhd.
Investors remain anxious about the prospects of increased volatility and uncertainty in the capital markets whereas futures traders welcome markets that are in a continuous state of flux.
In order to analyze the impact of market volatility on the derivative market in India, it is essential to understand the derivative market first.
The derivative markets can be defined as the financial market for derivatives (a derivative is a contract that derives its value from the performance of an underlying entity.) and financial instruments namely futures contracts or options, that derive their value from other forms of assets.
There are four types of Derivative contracts that you must know before making choices in a commodity market:
Options- Options are financial derivative contracts that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specific price during a specific period of time.
Futures- These contracts are standardized one as they are traded on the exchange market and allow the holder of the contract to buy or sell the respective underlying asset at an agreed price on a specific date. Futures contract parties not only possess the right but also are under the obligation, to carry out the contract as agreed.
Forwards- These contracts also possess the right and obligation to carry out the contract as agreed similar to futures contracts. However, forwards contracts are over the counter products, which means they are not regulated and are not bound by specific trading rules and regulations therefor, they are customizable to suit the requirements of both parties involved.
Swaps-When derivative contracts involve two holders, or parties to the contract, to exchange financial obligations are called Swaps. They are traded over the counter and not traded on the exchange market.
There are many platforms available for derivatives trading namely, NSE, BSE, and Multi Commodity Exchange. While MCX deals with commodities and NSE and BSE deal exclusively in stocks. These platforms enable you to trade in derivatives instruments and future and options are the most common type of derivatives in India.
Before understanding whether volatility affects the derivatives market favorably; let’ shave a look at what is volatility and factors that affect the volatility of the market.
Any market is called “volatile” when the stock prices rise and fall more than one percent over a sustained period of time.
Volatility means the amount of uncertainty or risk associated with the size of changes in a security’s value. It shows that the price of the security can change dramatically over a short period of time in either direction. A lower volatility means that a security’s value does not fluctuate dramatically, and tends to be stable.
There are a number of various regional and national economic factors (tax and interest rate policies) that can significantly contribute to the directional change of the market and influence volatility to a large extent. For instance, in many countries, when a central bank sets the short-term interest rates for overnight borrowing by banks, their stock markets often violently react.
Apart from that, there are various industry and sector factors that can influence long-term stock market trends and volatility as well. Changes in inflation trends also influence the market volatility. For example, a major weather event in a key oil-producing area can result in a rise in oil prices, which eventually increase the price of oil-related stocks.
Traders always look for “hot” news and enter the market first before others, so that they can make quick profits. Basically, derivative markets require market volatility, that’s where all the trading opportunities present itself.
Let’s understand it by an example;
If the news is unfavorable for investors, the expected impact would naturally be a sell-down in the market. So what the investor should do? Sell futures. When the price drops, an investor tends to choose a point to buy back and close the earlier futures position that you had sold. Trade has done!
Futures traders make great efforts in dealing with volatility. They move in swiftly, analyze, and make a decision on where he/she thinks the best possible option.
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